For many, the overarching goal is retirement. This stage of life isn’t just a change in their lifestyle but a time when their personal mutual fund portfolio needs serious changes made. During retirement, an overwhelming number of investors must change their mindset from accumulating assets to withdrawing them.
This is a very fundamental change, and it requires two things:
- An honest assessment of how much income is necessary for the lifestyle the investor wants to enjoy
- An equally honest re-evaluation of the risk tolerance and return objectives of the portfolio
A mutual fund asset allocation strategy in retirement that proves effective should accomplish three things:
- Provide sufficient income to last as long as the investor is alive
- Have enough cash for emergencies that might happen
- Enough growth to prevent asset erosion
Retirees faces three primary challenges in trying to accomplish this:
- Coming with a proper allocation strategy to deal with realistic income withdrawal rates
- Predicting how much money will be necessary for emergencies
- Incorporating enough growth within the portfolio to provide protection from rapid asset depletion
Assessing all these factors makes you a savvier investor.
Table of Contents
The Income Level Needed
The first thing you need to estimate is how much you need in terms of annual living expenses. Then, you need to decide how much pre-tax income you need in retirement. A good rule of thumb is that your retirement expenses will be 70% to 80% of your income before retirement.
However, many retirees might also add expenses, such as club memberships or more travel. Itemize your current expenses to get accurate predictions while adding or subtracting expenses adjustments as you need to.
In order to calculate your pre-tax number, you should divide your retirement expenses by one while also subtracting your tax bracket.
Once you know your pre-tax income prediction, ascertain the necessary income you’d need from your portfolio of mutual funds while subtracting any distributions from pensions, Social Security, or other income sources such as limited partnership and individual stocks.
Remember, withdrawals from any tax-deferred accounts, such as 401(k) or a traditional IRA, will be treated just like taxable income.
High-income earners should note the ramification of potential tax rates in the future. For instance, the Affordable Care Act of 2010 imposed 3.8% Medicare surtaxes on incomes more than $200,000 for individual filers and $250,000 for any joint filers.
This tax was slated to start in 2013. It will be assessed on the lesser of modified adjusted gross income or net investment income exceeding income thresholds for both joint and single filers.
Calculating unearned contribution taxes for Medicare will include pass-through income coming from passive business, interest, capital gains, royalties, rents, annuities, and dividends.
Some kinds of income won’t be subject to this tax, including tax-exempted municipal bond interest, capital gains excluded from selling a principal residence, nontaxable veteran’s benefits, and distributions from profit-sharing plans, pensions, 457 plans, 401(k) plans, 403(b) plans, and both Roth and traditional IRAs.
Case A: A couple filing jointly or single filer exceeds the MAGI thresholds with a zero net income from investments. There will be no Medicare surtax.
Case B: A couple filing jointly or single filer falls under MAGI thresholds at $100,000 worth of net investment income. Since excess MAGI thresholds didn’t occur, there is no Medicare surtax.
Case C: A couple filing jointly or a single filer exceeds the MAGI thresholds by an amount of $40,000 and there is a $50,000 net investment income. A 3.8% Medicare surtax totaling $1,520 applies to the amount of $40,000 excess MAGI given how it is less than net investment income of $50,000.
Case D: A couple filing jointly or a single filer exceeds the MAGI thresholds by an amount of $40,000 and there is a $30,000 net investment income. A 3.8% Medicare surtax totaling $1,140 applies to the amount of $30,000 net investment income due to how it is less than $40,000 excess MAGI.
Predicting Emergency Needs
Once you figure out a yearly pre-tax income, you need to ascertain how much money you might need for emergencies.
In the pre-retirement years, the conventional thinking is usually keeping three to six months of your living expenses in either a money market fund or something equivalent.
The thinking behind this is to be sure that growth-oriented strategies for long-term investing could keep going without interruption.
On the other hand, you need to account for surprise expenses, such as home repairs, medical bills, or market downturns while you’re in retirement. As such, you should have as much as a year’s worth of your living expenses in either:
- A money market fund
- A very short-term bond fund
- A short-term treasury bond fund
Do note that it’s ‘up to a year’ as the recommendation. Many current retirees decide to just keep six months of their living expenses to cover emergencies. Your actual number will be based on personal circumstances and your own comfort level.
A number of financial advisors suggest allocations as high as 10% of your assets for emergencies in a long-term portfolio focused on income.
Having said that, if you have a time horizon of less than half a decade, then you might want to bump that up to 15% or even 20% in conjunction with a short-term bond fund with government assets or a general money market fund.
Generally speaking, your portfolio size and full year of estimated living expenses should decide your emergency reserve more than a flat percentage guideline.
Sufficient Portfolio Growth
After you know how much you need for pre-tax income and emergencies, then you need to deal with the role that growth should have within your retirement portfolio.
Just how much allocation you put into growth will be based on how much income you need and the overall size of your portfolio.
Based on the number of your assets, your retirement portfolio growth purpose could be several different things:
Protection From Asset Inflation Erosion
Assume the historical rate of inflation at 3%. A contemporary income of $40,000 needs an income of around $72,000 in two decades to maintain its current acquiring power.
Unless your particular portfolio grew enough to offset the impact of inflation, you’d have to take one or two steps:
- Withdraw your assets at a rate higher than the earnings of the portfolio. This would shorten the life of your portfolio, such as withdrawing 10% if you only earn 8%.
- Lower your living standards substantially, which most retirees would detest doing.
Protection From Portfolio Depletion
If your portfolio withdrawal rates exceed the earnings rates, then the life of the portfolio is going to diminish. Assume an example that excludes taxes and inflation.
Withdrawing 10% each year from your portfolio that earns 6% each year will deplete all assets in just 15 years.
A portfolio withdrawing 12% each year with 6% earnings annually would deplete in less than 12 years.
Anytime withdrawal rates outpace earning rates, the portfolio needs enough growth to keep the assets in place over the course of life expectancy. The tables that follow show how different withdrawal rates can last for a certain number of years.
Remember that these examples don’t include taxes or inflation, and both of those can accelerate the demise of a portfolio:
A Portfolio Earning 4% Each Year
- Rates of Annual Withdrawal | Years Left Until Total Depletion
- 5% | 34.0
- 6% | 27.0
- 7% | 20.9
- 8% | 17.2
- 9% | 14.6
- 10% | 12.7
A Portfolio Earning 6% Each Year
- Rates of Annual Withdrawal | Years Left Until Total Depletion
- 7% | 0.5
- 8% | 22.4
- 9% | 17.8
- 10% | 15.0
- 11% | 12.9
- 12% | 11.4
A Portfolio Earning 8% Each Year
- Rates of Annual Withdrawal | Years Left Until Total Depletion
- 9% | 24.9
- 10% | 19.0
- 11% | 15.6
- 12% | 13.2
- 13% | 11.7
- 14% | 10.3
Protection for Life Expectancy Increases
Growing awareness about nutrition combined with advances in science and medicine has led to serious increases in the life expectancies of both genders. Sufficient portfolio growth is essential to make sure you don’t outlive the assets in your portfolio.
Estate-Oriented Portfolio Growth
If one of the goals you have is to pass on assets to heirs, then you need to make sure that some of your portfolio is in equity funds.
Just like the rest of the portfolio, your stock funds need to be effectively diversified and reflect your identified risk tolerance level.
Key Takeaways about portfolio changes in retirement
Ideal portfolios generate their income through bond fund yields, whereas sufficient emergency reserves are kept in a money market fund or a short-term bond fund.
The rest of the portfolio assets would be allocated towards equity funds to account for growth.
However, quite a few retirees get to a point where they use capital appreciation or distributions from equity funds accounting for growth allocation in order to counter inflation or supplement their income.
This can work, but you must remember that those equity fund dividends are paid twice a year, whereas capital gain distributions if they happen, get distributed annually. Budget your expenses accordingly.
With any objective, whether it focuses on income, balance, or growth, the risk tolerance level can be conservative, moderate, or aggressive.
How much volatility that you as a retiree would deem acceptable will determine the risk tolerance level you choose.
Retirees frequently choose lower levels of tolerating risk when they’re still accumulating assets. Their portfolio risk tolerance might stay the same in retirement, but it almost never goes up.
No matter your risk tolerance or return objectives, your portfolio needs to provide sufficient diversification by spreading out the assets among a variety of unique fund categories so that you get a spread of different risk/reward objectives and can reduce your total portfolio risk.
Track your portfolio and expenses at least on a yearly basis. Look for any big changes in your individual asset mix or spending.
If you assume that risk tolerance and objectives don’t change, then your portfolio needs to be rebalanced to its initial allocation mix when your income needs don’t change much.
On the other hand, should your income need change drastically, then you should reconsider your plan regarding the income you need, your emergency reserve, and then having enough growth.